Most of us are familiar with Aesop’s timeless fable of “The Tortoise and the Hare” and its token characters. After bolting to an early lead, the overconfident hare stops for a nap. Meanwhile, the tortoise maintains a steady pace, albeit a slow one, which is enough to overtake the sleeping hare. By the time the hare awakens, it’s too late to catch up, and the slow and steady tortoise wins the race. It’s a simple tale encouraging perseverance over arrogance, and like many fables, its layers resonate deeply across various aspects of life, including the world of investing.
When investing for the long term, we all know returns matter. But if you only look at returns, that’s analogous to only comparing the speed of the hare to that of the tortoise. The often-overlooked side of the equation is the volatility required to generate those returns. In the same way that stopping and napping cost the hare the race, even though he was the faster runner, volatility can slow the growth of wealth over the long term. This concept is known as “volatility drag.”
As an example, let's imagine an investment with a 50% loss one year, followed by a 50% gain the next. Intuitively, it might seem that the investment broke even over the two years, but let’s do the math. If you start with $100, a 50% loss reduces it to $50. A subsequent 50% gain then increases it to only $75. Overall, the investment has lost 25% over the two years.
Now we look at the same example but with reduced volatility (a lower volatility drag). Say the investment loses 10% one year and gains 10% the next. Starting with $100, a 10% loss brings it to $90. The subsequent 10%gain ($9 in dollar terms) increases the value to $99. It’s still an overall loss of 1% or $1, but it’s not nearly as bad as the first example, despite each example having equal and opposite returns from year to year.
To put it simply, volatility drag means that if a portfolio's value fluctuates significantly, the portfolio needs to work harder to return to its original value. In contrast, if we can limit the size of the downturns, the portfolio doesn’t have to work as hard to recover, and all else equal, less volatility likely leads to more growth over the long term. In the context of our fable, if we knew the hare could maintain his breakneck pace100% of the time, he would be the obvious choice, but given the hare’s propensity for stops and starts, the slow and steady tortoise is the better bet for the long term.
A Real-World Example
Let’s look at the market drop of 2022 and the subsequent market rise of 2023 through the returns of three U.S. benchmarks: Dimensional US Core Equity 2 ETF (DFAC), the S&P 500 Index and the Nasdaq Composite Index.
For 2023, DFAC was up nicely at 22.0%. The S&P 500 was up even more at 26.3%. The Nasdaq was up a breathtaking 44.6% (the Nasdaq was the place to be in 2023).
Let’s now go back one more year to 2022 when all three benchmarks dropped in value. DFAC dropped the least, down 14.9%. The S&P500 was down 18.1%. The Nasdaq dropped by nearly a third of its value, down 32.5%.
Putting 2022 and 2023 together, DFAC was up 3.8% over both years. The S&P 500 was up 3.4%. The Nasdaq was down 2.4%.
Even with the remarkable 2023 return of the Nasdaq, volatility contributed to its third-place finish as the weakest performer across the three benchmarks. It performed much like the hare, and the one that lost the lost the least (DFAC) — in other words, had the lowest volatility drag — was the tortoise that won the race.
Takeaways for Investors
This fable reminds investors of the importance of patience and the risks of overconfidence. Just as someone who only saw the tortoise and hare at the beginning of the race would be surprised by the outcome, so too can we be surprised and disappointed by the outcome of chasing high returns without considering the impact of volatility.
The hare's approach in the story mirrors the allure of high-volatility investments, which promise substantial returns in a short period. While these can be tempting, they come with the risk of significant losses that require extraordinary gains to recover, as exemplified by the hare's decision to rest and ultimate failure to recover.
The tortoise’s approach underscores the value of consistency. For investors, this means diversifying one's portfolio to include a mix of assets to maximize after-tax wealth for the right amount of risk. At any given time in a diversified portfolio of stocks and bonds, there will be an asset class that appears to be a drag on the portfolio. Over time, though, the leaders and laggards will rotate positions, and this diversification tends to reduce volatility of the overall portfolio. By balancing return and volatility, investors can mitigate the effects of severe downturns and subsequent volatility drag, ensuring their portfolio moves forward steadily, even if it doesn't always lead the race.
In classic parable fashion, “The Tortoise and the Hare" offers timeless wisdom that transcends its original moral. In the world of investing, just as in Aesop’s fable, sometimes slow and steady does indeed win the race.
Patience rewarded.